Earnings Call Transcript - ST Q3 2021

Operator, Operator

Good day, and welcome to the Sensata Technologies Q3 2021 Earnings Call. Please note, this event is being recorded. I would now like to turn the conference over to Mr. Jacob Sayer, VP, Finance. Please go ahead.

Jacob Sayer, VP, Finance

Thank you, Sara. Good morning, everyone. I'd like to welcome you to Sensata's third quarter 2021 earnings conference call. Joining me on today's call are Jeff Cote, Sensata's CEO and President; and Paul Vasington, Sensata's Chief Financial Officer. In addition to the financial results press release we issued earlier today, we will be referencing a slide presentation during today's call. The PDF of this presentation can be downloaded from Sensata's Investor Relations website. This conference call is being recorded, and we'll post a replay webcast on our Investor Relations website shortly after the conclusion of today's call. As we begin, I'd like to reference Sensata's Safe Harbor statement on Slide 2. During this conference call, we will make forward-looking statements regarding future events or the financial performance of the company that involve risks and uncertainties. The company's actual results may differ materially from the projections described in such statements. Factors that might cause such differences include, but are not limited to, those discussed in our Forms 10-Q and 10-K as well as other subsequent filings with the SEC. On Slide 3, we show Sensata's GAAP results for the third quarter of 2021. We encourage you to review our GAAP financial statements in addition to today's presentation. Most of the subsequent information that we will discuss during today's call will relate to non-GAAP financial measures. Reconciliations of our GAAP to non-GAAP financial measures are included in the earnings release and in our presentation materials. The company provides details of its segment operating income on Slides 12 and 13 of the presentation, which are the primary measures management uses to evaluate the performance of the business. Jeff will begin today’s call with highlights of our business during the third quarter of 2021, followed by a quick review of our first sustainability report published recently. He will then provide an update on recent progress in our key Electrification and Sensata Insights strategic growth areas. Paul will cover our detailed financials for the third quarter of 2021, including organic revenue growth and market outgrowth by business as well as segment performance. And he will also provide financial guidance for the fourth quarter of 2021. We will then take your questions after our prepared remarks. Now I'd like to turn the call over to Sensata's CEO and President, Jeff Cote.

Jeff Cote, CEO

Thank you, Jacob, and welcome, everyone. I'd like to start with some summary thoughts on our strong performance during the third quarter of 2021, as outlined on Slide 4. The business recovery that began this time last year continued during the third quarter. We responded effectively to increased customer demand which drove 20.6% revenue growth from the prior year period to $951 million, slightly above the guidance range we provided in July. While automotive production was constrained during the quarter due to supply chain shortages, we were able to deliver our customers' orders and produce strong financial results for shareholders. Looking at our performance year-over-year, we once again produced strong market outgrowth well above our target ranges. As a company, we delivered 1,190 basis points of outgrowth during the quarter. However, outgrowth is something that we monitor over a longer period of time than one quarter. And since 2018 on average, we’ve produced 570 basis points of outgrowth as a company, driven by a 1,050 basis points outgrowth in our heavy vehicle, off-road business and 650 basis points outgrowth in our automotive business. This demonstrates the vital role we provide for our customers in these key markets. Paul will discuss our strong revenue outgrowth in more detail. Sensata's revenue outgrowth to market will increasingly be driven by our enhanced positioning in megatrend areas. We continue to invest in these growth initiatives both organically and inorganically. With Xirgo and now the pending acquisitions of Spear Power Systems and SmartWitness expanding not only our capabilities but also our access to end markets and product portfolios in these pivotal areas. Already we have seen strong revenue growth coming from our electrification activities. With more than $220 million estimated revenue this year, we expect continued significant growth in our megatrend areas over the coming years, driven by electrification trends, the infrastructure requirements to support electrification, and the proliferation of IoT on stationary and mobile equipment. Sensata today is in a very strong financial position, in part because of our excellent performance over the past year. We have generated more than $530 million in free cash flow over the past 12 months. And our current cash balance of $2 billion enables Sensata to continue to acquire targeted, innovative businesses that will expand our presence in our targeted growth vectors. During the third quarter, we benefited from our resilient, flexible, and focused organization that continues to successfully navigate the ever-changing supply chain landscape and deliver on our customers' needs. Not surprisingly, we continue to see elevated costs related to the worldwide material shortages and logistics costs. We are working diligently to limit those effects, including a different commercial approach with our customers. This is a challenging exercise, but very necessary under the current circumstances. Despite these elevated costs, we delivered $201 million in adjusted operating income during the quarter, representing 21.1% in operating margin, substantially higher than the prior year period. I'd like to recognize the innovation, agility, and hard work of our entire team achieving these strong results during the third quarter. During the quarter, Sensata published its first sustainability report, and we're very proud of our progress in these areas. Virtually every product Sensata makes today resulted in a cleaner, safer, and more efficient world. We also take our responsibility to reduce the carbon emissions from our own operations and our supply chain very seriously. To that end, we are targeting a 10% reduction in our greenhouse gas emissions intensity by 2026, and we have established a goal to be carbon neutral by 2050, in line with leading companies around the world. In addition, our report addresses sustainability topics core to Sensata's mission, including diversity, equity, inclusion, and responsible sourcing. We believe that diversity benefits our employees, customers, and shareholders, and that a diverse workforce makes us a better company. We have established goals for our leadership team to improve female representation in management roles at Sensata to 30% and to reach 25% racial diversity in U.S. management roles by 2026, while reducing turnover, improving internal development, and promotion rates. We are serious about achieving meaningful progress against these goals and, consequently, are tying a portion of our senior executives' short-term incentive compensation to annual improvements. We look forward to keeping all our stakeholders updated on these and other important ESG initiatives in the coming years. Moving to Slide 6. Sensata is making excellent progress in winning new business and electrification components, in part because we take a holistic view of electrification and its growing impact on all the segments we serve. Electric light vehicles capture a lot of attention, and Sensata provides the manufacturers of these vehicles with not only new EV-specific components, but also with many of our innovative and differentiated components from traditional vehicles, like braking, tire, and environmental control. Specific to EVs, we also provide and are developing several components that enable safe and efficient operation of electrified platforms, such as high voltage electrical protection, advanced temperature sensing, highly sensitive electric motor position, and next generation current sensing. As an example, during the third quarter, we were awarded new e-motor position business with a large European OEM representing $2.6 million in annual revenue. In addition, we benefit from the upgrading of certain systems in EVs. For example, when the climate control system is upgraded to a heat pump to manage the temperature of both the cabin as well as the battery pack, the sensor packages are upgraded and Sensata benefits. In the important area of braking, Sensata is a global leader. During the quarter, we won two new business opportunities that were significant. One with brake system leader Continental for new electronic stability control systems, covering both traditional internal combustion engine vehicles as well as a greater than $11 million in new business on electric vehicles that further extends our leadership position in that market. We have described the revenue increase that we received from EVs as compared to internal combustion vehicles in terms of an average 20% uplift in content per vehicle. This is a demonstrated figure based on actual revenues and vehicle production. Our design win activity within electrification has been growing rapidly. We saw an 80% rise in electrification wins last year, and so far this year, approximately 50% of our automotive design wins are with electric vehicles, another dramatic uptick from the prior periods. Looking forward based upon the business wins we're gaining and the products we are developing, we estimate that our battery electric vehicle content is on path to double that of an internal combustion engine vehicle on average within 5 years. On Slide 7, we show how Sensata is expanding in clean energy solutions, moving up the stack from high voltage components used by large customers with the resources to design these into their electrified offerings to subsystems and full battery energy storage systems for customers in a multitude of end markets. Electrification is happening everywhere, not just in passenger vehicles. Manufacturers of bikes, heavy trucks, material handling equipment, marine vessels, and even aircraft and spacecraft are addressing ever-tightening greenhouse gas emissions regulations and taking advantage of falling battery costs to provide electrified solutions to their customers. However, not all of these customers can design all aspects of the electrified solution in-house. Thanks to capabilities we have added via acquisition, Sensata can now provide either the subsystem of assembled components to manage battery charging in the form of a power distribution unit, or using technology for lithium balance and Spear Power, we can provide the full energy storage system, including battery management and a customized battery pack. By providing a full suite of offerings, our electrification and clean energy solutions serviceable addressable market expands dramatically, reaching $15 billion by 2030. As an example of the solutions we offer, during the quarter, a large premier European heavy vehicle OEM awarded Sensata on the design for a megawatt-size charging unit to help power their future electric commercial vehicles. This strategically important business win is worth more than $20 million in annualized revenue once it reaches its expected production run rate. Its pivotal development means we can increase our content per heavy truck from the current $100 to $200 on average to more than $1,000 per electric heavy vehicle. In addition, through the pending acquisition of Spear Power, we can provide full battery storage systems for a variety of specialty transportation markets. For example, Spear is powering electric ferries, including the upgrading to electric of the Washington State ferry system. These are highly demanding solutions that include very robust safety features proprietary to Spear, and we are excited about the role Spear is playing in these and other land, sea, and air transportation markets. Similar to what we did for our Insights group back in June, in early 2022, we will webcast a session covering our electrification components and clean energy solutions initiatives. So listeners can gain a better understanding of our offerings, the evolving markets, and our go-to-market strategies in these key growth vectors for Sensata. We look forward to sharing more details about these rapidly growing and evolving areas then. On Slide 8, we share an update on our continued progress in Sensata Insights. The Insights initiative addresses a fast and growing market, and we're pleased by the traction we are gaining with both current and new customers across various sectors. The ongoing widespread semiconductor shortage is constraining our Insights business, and we are unable to deliver on all of that expanding demand. You'll recall that these solutions are designed into our customers' fleets, the revenue is sticky, and so our orders are building for future delivery. Once the shortages subside, our Insights order book for delivery over the next 12 months now stands at more than $85 million, as evidenced by the value-added nature of our solutions. We were recently awarded new business with telematics service providers in a large global shipping company, together worth more than $9 million in revenue over the next 12 months. I'm also pleased to announce the expansion of our Insight offering with the pending acquisition of SmartWitness, a privately held innovator of video telematics technology for heavy and light-duty fleets. SmartWitness solutions comprise proprietary software and hardware, purpose-built for telematics service providers, providing a complimentary fit with our Insights business. Since its founding in 2007, SmartWitness has been a pioneer in video telematics that expands on traditional offerings to include contextually aware data capture that enhances the monitoring of vehicles and their surroundings to increase safety and lower insurance costs for fleets. SmartWitness systems are logging 50 million miles of information every day. In summary, we are really encouraged by our continued progress in our megatrend growth initiatives. As I've said before, we see numerous opportunities to utilize our strong financial position, our engineering capabilities, our supply chain, and our customer relationships to meaningfully enlarge our addressable markets through organic efforts as well as bolt-on acquisitions and partnerships within these megatrends.

Paul Vasington, CFO

Thank you, Jeff. Key highlights in the third quarter, as shown on Slide 10 include, revenue of $951 million, an increase of 20.6% from the third quarter of 2020. Organic revenue increased 16.6%. The acquisition of Xirgo increased revenue by 2.3%, and changes in foreign currency increased revenue by 1.7%. Adjusted operating income was $201 million, an increase of 29.8% compared to the third quarter of 2020, primarily due to higher revenues, partially offset by elevated costs related to the industry-wide supply chain shortages, higher spend to support megatrend growth initiatives, and higher incentive compensation aligned to improve financial performance. Adjusted net income was $138.6 million, an increase of 33.8% compared to the third quarter of 2020, largely due to the significant increase in operating income. Adjusted EPS was $0.87 in the third quarter, an increase of 31.8% compared to the prior quarter. Now, I will discuss our performance by end market in the third quarter of 2021 as outlined on Slide 11. Organic revenue increase of 16.6% year-on-year includes market growth of 470 basis points and outgrowth of 1,190 basis points, again demonstrating Sensata's ability to consistently outgrow its end markets. Our automotive business posted an organic revenue increase of 5.2%, representing end market contraction of 21.6% and 1,150 basis points of market outgrowth. Our automotive business benefited from new product launches in powertrain and emissions, safety, and electrification-related applications and systems. Recall, we saw an approximate $35 million inventory contraction a year ago as the automotive industry ramped up production from slowdowns earlier in 2020. In addition, we were able to fulfill customer orders within the current quarter even if those shipments exceeded the eventual production in the quarter due to other component delays. Within the third quarter of 2021, we estimate an incremental build quarter-over-quarter of approximately $35 million of inventory at our customers. Our industrial business revenue increased 17.9% organically as global industrial end markets continued to recover in the quarter. Strong growth in new electrification launches and heating, ventilation, and air conditioning enabled our industrial business to grow faster than the market this quarter. Our aerospace business increased 8.3% organically, reflecting somewhat improved OEM production in air traffic that later drives our aerospace aftermarket business. New product launches, primarily in defense and improvements in aftermarket, enabled our aerospace business to grow faster than the market this quarter. Now I'd like to comment on the performance of our two business segments in the third quarter of 2021. Starting with Performance Sensing on Slide 12. Our Performance Sensing business reported revenues of $706.5 million, an increase of 21.6% compared to the same quarter last year. Excluding the positive impact from foreign currency of 1.8% and the positive impact on the Xirgo acquisition of 3.1%, Performance Sensing delivered 16.7% organic revenue growth. Performance Sensing operating income was $193.7 million, an increase of 27.8% as compared to the same quarter last year, with operating margins of 27.4%. The increase in segment operating income was primarily due to higher revenues somewhat offset by elevated costs related to the industry-wide supply chain shortage. Performance Sensing generated incremental margin of 37% in the quarter of higher organic revenue as compared to the prior year period. As shown on Slide 13, Sensing Solutions reported revenues of $244.6 million in the third quarter of 2021, an increase of 17.9% as compared to the same quarter last year. Excluding the positive impact from foreign currency of 1.5%, Sensing Solutions delivered 16.4% organic revenue growth. Sensing Solutions operating income was $75.3 million, an increase of 29.3% from the same quarter last year, with operating margins of 30.8%. The increase in segment operating income was primarily due to higher revenues. Sensing Solutions generated incremental margin of 46% in the third quarter and higher organic revenue as compared to the prior period. On Slide 14, corporate and other operating expenses not included in segment operating income were $72.7 million in the third quarter of 2021. Excluding charges added back to our non-GAAP results, corporate and other costs were $65.7 million, an increase of $12.3 million from the prior quarter, reflecting higher research and development and business development spending to support our megatrend growth initiatives and higher global incentive compensation costs aligned to our improving financial performance. Slide 15 shows Sensata's third quarter 2021 non-GAAP results. Adjusted operating income increased 29.8% compared to the same quarter last year, and adjusted operating margin increased 150 basis points to 21.1%. The increase in both adjusted gross margin and adjusted operating margin largely reflects the rapid increase in revenue from depressed levels experienced last year due to COVID-19 pandemic, offset somewhat by increased costs related to industry-wide supply chain shortages, net of recovery of some of these costs from customers. We've included on the slide an adjusted operating income margin loss from the third quarter of 2020 to the third quarter of 2021. As shown on Slide 16, we generated $80 million in free cash flow during the third quarter. Free cash flow was impacted in the quarter by our decision to increase raw material purchases early in the quarter in order to maximize production flexibility, given the widespread parts shortages in our supply chain. For the full year, we currently expect free cash flow conversion to be approximately 80% of adjusted net income as a result of higher inventory levels. For the full year 2021, we expect capital expenditures to be in the range of $145 million to $155 million. Sensata's net debt to EBITDA ratio was 2.5x at the end of September, the bottom end of our target operating net leverage range. Sensata's primary use of cash on hand is to acquire businesses that will extend our market position within our key growth factors of electrification and Insights. In addition, we intend to resume our share repurchase program within the fourth quarter. And as noted, we have $302 million available on our current purchase authorization. We are providing financial guidance for the fourth quarter of 2021 as shown on Slide 17. Our expectations are based upon the end market outlook that I will discuss momentarily. We expect to generate revenues between $895 million and $920 million in the fourth quarter of 2021, representing a reported revenue change between 1% decline and 2% growth compared to the fourth quarter of 2020. With the impact of foreign currency, increasing revenues at the midpoint of guidance by about $2.6 million. Excluding the impact of foreign currency in the Xirgo acquisition, we expect an organic revenue change ranging from a 3% decline to flat in the fourth quarter. Our current fill rate is approximately 95% of the revenue guidance midpoint for the fourth quarter. We expect to report adjusted operating income between $180 million and $190 million. At the midpoint, adjusted operating income margin is expected to be 20.3%, which includes 100 basis points of increased operating costs associated with global supply chain shortages net of customer recovery actions. On the bottom line, we expect to report adjusted net income between $121 million and $131 million and adjusted EPS between $0.76 and $0.82, which includes a $0.02 increase from foreign currency at the guidance midpoint. At the bottom of the slide, we've provided an adjusted operating income margin walk from the fourth quarter of 2020 to the fourth quarter of 2021. On Slide 18, we provided our revised estimates for OEM production growth for 2021 as compared to the expectations we shared in late July. We currently expect automotive productions to be down approximately 3% this year from last year, given ongoing production slowdowns caused by global supply chain shortages. Our outlook is more conservative than IHS automotive production estimates for the fourth quarter, as we do not see production constraints from the global supply chain shortages lifting in the near-term. While we are not sharing specifics yet, the current IHS global automotive production expectations of 10% growth in 2022 suggest that supply chain shortages will be considerably mitigated next year, a view we do not share given current trends. We intend to provide detailed financial guidance for 2022 during our fourth quarter earnings call in early February. However, at a high level, we currently expect Sensata's revenue growth in 2022 to align with the growth framework we have previously shared. Sensata's revenue by end market should grow consistent with each market's production growth, plus our target outgrowth for approximately 400 to 500 basis points across the whole company. In addition, we intend to continue our serial M&A approach to further expand our market position. In our megatrend areas, we aim to have this activity at a material amount to revenue growth each year.

Jeff Cote, CEO

Now let me turn the call back to Jeff for closing comments. Thanks, Paul. Let me wrap up with a few key messages as outlined on Slide 19. Sensata has responded very well to the rapid changes in many of our end markets, demonstrating the strength, resiliency, and reliability of our business and organizational model, which enabled us to capitalize on this recovery in the end market demand and deliver for our customers. Our quick response to shifting demand positions us well as a trusted resource for our customers. We are delivering consistently robust end market outgrowth. We remain confident in our ability to sustain this attractive end market outgrowth into the future based on our strong levels of new business awards and our large and expanding pipeline of new opportunities. We continue to invest in our megatrend-driven growth initiatives that are opening up large and rapidly growing opportunities for Sensata across all of our end markets. We are making excellent progress in electrified components, clean energy solutions, and Sensata Insights, both through organically targeted areas around new business and through inorganic activity associated with bolt-on acquisitions. We continue to believe that the overall business environment provides interesting opportunities to further strengthen our portfolio through strategically important value-creating acquisitions and/or joint ventures. In addition, we are pursuing new technology collaborations and partnerships with third parties to expand our capabilities and accelerate our megatrend-driven growth potential. We expect to continue to deliver industry-leading margins for our shareholders while also increasing investments in our growth opportunities and our people. And finally, I'm excited about Sensata's long-standing mission to help create a cleaner, safer, and more connected world, not just for our customers' products, but also through our own operations. We believe we are meaningfully contributing to a better world. We are incorporating ESG considerations into our strategy, as illustrated in our new sustainability report to bolster the long-term sustainability and success of the company for all of its stakeholders. We look forward to reporting more about our progress in these areas in future updates. Now, I'll turn the call back to Jacob.

Jacob Sayer, VP, Finance

Thank you, Jeff. We'll now move to Q&A. Given the large number of listeners on the call, please limit yourself to one question each. Sara, please go ahead and assemble the Q&A roster.

Operator, Operator

Our first question comes from Wamsi Mohan with Bank of America. Please go ahead.

Wamsi Mohan, Analyst

Yes, thank you. I was wondering if you could maybe just give us some more color on the channel fill dynamics, how broad-based this is? If we use $30 to $40 of content per vehicle, we're talking about roughly a million units. But the production changes are quite large and Jeff, you know that, that going into '22, it seems that IHS maybe is a bit too optimistic. So is the guide sort of a Q4 encapsulating all the channel inventory dynamics? Or do you think this persists into 2022? And if I could, could you also just maybe quickly talk about the China issues, both around power rationalization and resurgence of COVID, if you're seeing any impact from that? Thank you so much.

Jeff Cote, CEO

Sure. Let me discuss Q4. IHS projects automotive production to be around 16.5 or 16.6 million units, while we have estimated it to be lower, around 15 million. Additionally, since we've noticed some of our parts accumulating in inventory, we anticipate a slight reduction in that. I believe this is a somewhat cautious estimate, but we are monitoring it closely. Our priority is to ensure we do not overproduce for customers only for it to remain unsold in inventory. We prefer to manage these situations as they arise and serve other customers since the shortages are affecting all our clients across various markets. Regarding 2022, we are not issuing guidance, but we like to forecast as everyone else does, particularly concerning the automotive sector. Historically, IHS has been a bit aggressive with their forecasts, and considering the supply chain issues we’re currently experiencing, it seems these challenges will likely continue into 2022. On a positive note, the commitment levels from our suppliers indicate that the fourth quarter may represent the lowest point for delivery capabilities. As increased capacity becomes available, we expect a gradual improvement from the fourth quarter levels. We will continue to monitor this situation closely. Moreover, we recognize the significant inventory that has been accumulated, understanding that North American vehicle inventory is at a record low of 24 days, which will eventually need to be replenished. There are numerous factors to consider in the overall outlook, and we must also evaluate the other markets we operate in. The automotive sector is a substantial one for us, but there are still opportunities for growth in other markets as we proceed into Q4 and 2022. Concerning the situation in China, especially related to COVID and other factors, our business is performing quite well there. We have shown great resilience, as has everyone else during these challenging times. Currently, we do not see any significant impact from COVID, aside from continuing to follow safety protocols. In the U.S., we are addressing the executive order related to vaccine mandates, ensuring our employees are safe. Overall, I feel that we have adapted well to these circumstances, which seem to have become somewhat routine for us. I hope that answers your question, Wamsi.

Jacob Sayer, VP, Finance

Thank you, Wamsi.

Operator, Operator

Our next question comes from Matt Sheerin with Stifel. Please go ahead.

Matt Sheerin, Analyst

Yes, thank you and good morning. Jeff, I just wanted to ask regarding your comment about doubling the EV content in light vehicles in the next 5 years from the base of about, I guess, 20% incremental content today. Where in that product portfolio would you see that coming? Is that from your existing products and technologies? Or are there other incremental products or areas that you're looking at?

Jeff Cote, CEO

We have received mixed feedback, but it's clear that we are quite digital in our approach. The 20% increase was acknowledged as positive, but not overly exciting. Upon reflection, we recognize that we are currently demonstrating our capabilities. We have experienced significant growth in our wins with electrified components, both with automotive OEMs and other clients. We have seen major victories related to power distribution units and electrification. Our assessment indicates a natural transition toward more electrified vehicles. Based on our existing sales with customers, we anticipate a path to doubling our presence in this market. However, when we discuss net new business opportunities, it's important to note that a new application using the same socket does not contribute to recognized growth. There is substantial content in vehicles that applies to both battery electric and internal combustion engines, so we don't need to replenish our pipeline. A deeper evaluation of the trend, coupled with continued wins and the investments and partnerships we are forming, gives us strong confidence in our goal of doubling the content per vehicle. I hope this information is helpful.

Jacob Sayer, VP, Finance

Thank you, Matt.

Operator, Operator

Our next question comes from Amit Daryanani with Evercore. Please go ahead.

Amit Daryanani, Analyst

Thank you for taking my question. Jeff, when you discuss the guidance for the December quarter, it seems you're suggesting that Sensata's automotive revenues will be affected by auto production trends due to the depletion of your inventory in the channel. Is that correct? Can you explain how much extra inventory of Sensata is currently in the channel and how long it might take to return to normal levels? Additionally, Paul, could you clarify how cash flow goes back to an 80% conversion rate? Will that happen in December, or is that more of a narrative for the calendar year 2022?

Jeff Cote, CEO

Yes, so I'll hit the Q4, and then Paul can hit the other topic. So we've already stated we are expecting about 1.5 million units less than IHS in terms of actual production in the fourth quarter. But we also expect some of the inventory in the supply chain to deplete. So that's baked into the guide that we provided for the fourth quarter. In terms of the amount of inventory, call it a $100 million to $125 million of inventory across the company that's been built, that's been largely focused in auto. But I would also point out that if you also look at the North American vehicle inventory of 24 days, just replenishing that back to a more normalized 50 or 60 would absorb a lot of that inventory of the market. But as that production occurs, as that production is quoted assuming our customers actually normalize their raw inventory, we will see production exceed our revenue. Now, I think, it's a bit of a discussion that we're having with customers because they want all the parts we can make for them, right. They want to make sure that, given the complexity of their builds, they're very willing to carry a little bit more raw material now, but we want to make sure again that we're serving all of our customers. And it makes no sense for us to pay higher logistics costs and expedite these to get customers' product that sit in their inventory. So that's an ongoing dialogue that we're having and we'll continue to manage it very closely and give you updates as we see it.

Paul Vasington, CFO

So the question I think, is the 80% version relates to 2021. It's lower than we originally anticipated when we started the year, and we made a conscious decision to build inventory, take our raw materials earlier to make sure that we were able to serve customers consciously. For next year, I mean, we've been looking at a free cash conversion rate in the mid-80s. And that's what we're going to continue to target as good performance.

Jacob Sayer, VP, Finance

Okay.

Operator, Operator

Our next question comes from Mark Delaney with Goldman Sachs. Please go ahead.

Mark Delaney, Analyst

Yes, good morning and thanks very much for taking the question. So when you can elaborate on the supply chain dynamics that's underpinning some of the more cautious comments the company is providing as it thinks about the outlook for 4Q and also into next year? What are some of the most difficult things as it relates to supply chain for Sensata? Any particular components that are most short for the company? And if you could talk about the shortages you're seeing not only for Sensata, but what you think is maybe impacting some of your customers as well and any added color on that I think will be helpful. Thanks.

Jeff Cote, CEO

Yes, sure. So first, obviously, it's an industry issue. I think everybody understands that it's not specific to Sensata. It's most acute in electronics at the foundry level. So capacity at the foundry level, I think these are sort of pretty well-known facts, and that capacity takes a while to get put in place. Now, over the last 18 months, as that's been happening, obviously, our suppliers have been moving their capacity around to serve needs. I think we've done really well in terms of getting our fair share of that allocation. So that's a very positive thing. It's beyond electronics, though. I mean, we all experience it in our every day. Everything is short, right? Supply chain issues, not only a capacity demand question, but just logistics in general was very challenged in terms of finding labor to unload container trucks and so forth. So it continues to be a problem that everyone is experiencing. As we talked about in the past, many of our electronics are customized. So we feel as though we've been impacted less as a result of that, because in a lot of cases, those are areas that our suppliers would focus on as opposed to more standard off-the-shelf electronics. Candidly, that's what's impacting our Insights business a little more. The solution is differentiated and customized, but a lot of the electronics that go into it are more standard. So we're seeing a little bit more of a shortage and a crunch when there are standard ASICs that we're going after. And the last point I would make here is, during 2021, first half of the year, we were being partners with our customers, and we didn't go after a lot of this cost recovery. But in the second half of '21, we've had more direct conversations with them. We've had some very good success. And given that this is going to continue, both in terms of raw material costs and logistics costs, we're having those conversations with customers to make sure that Sensata shareholders are not the ones that take the hit. We want to be good partners, we want to deliver, but we need to share the costs associated with making sure we can continue to deliver.

Jacob Sayer, VP, Finance

Thank you, Mark.

Operator, Operator

Our next question comes from Luke Junk with Robert. Please go ahead.

Luke Junk, Analyst

Yes, thank you and good morning, Jeff. I would like you to elaborate on the expectation that the content is on track to double in the next five years. Specifically, can we discuss the key levers and drivers you are focusing on, particularly any products that you anticipate will be increasingly important for Sensata? It might be helpful to consider this in the context of power-related products compared to traditional sensing products. Any additional insights would be appreciated. Thank you.

Jeff Cote, CEO

Certainly. If you look back three to five years, most of our components were primarily for combustion engines. We have been open about our activities in mergers and acquisitions, as well as engineering investments, to ensure we can continue to support our customers in the future. We’ve consistently mentioned that even though we specialize in individual sensing parameters like pressure and temperature, we offer thousands of products. We utilize modular technology, packaging it to meet application needs with these traditional sensing parameters. The transition to electrified vehicles is not significantly different. For instance, we have the GIGAVAC capabilities and advanced levitation technology. We’ve also transformed our position sensors for e-motors and are developing current sensing capabilities. Many of our pressure and temperature products are relevant for electric platforms. Our aim is to ensure we provide multiple capabilities rather than relying on just one. We want to be integral to the EV platform. Our combination of capabilities and product solutions extends into other areas like high voltage current sensing and protection. We believe we have a strong portfolio to assist customers in overcoming their challenges. While electric vehicles currently represent a small share of the overall fleet, we are seeing numerous successes associated with the solutions we are providing. The rapid development of opportunities with our customers has accelerated our time to market, and this positive trend has boosted our confidence in the potential for significant growth for our company.

Jacob Sayer, VP, Finance

Thank you, Luke.

Operator, Operator

Our next question comes from Brian Johnson with Barclays. Please go ahead.

Brian Johnson, Analyst

Thank you. Just want to flesh out a little bit more the inventory question. I guess, first question is, a lot of the pure auto suppliers have very severe decrementals due to tough nature of production in the quarter. Is most of the work you do in automotive from a catalog and therefore not customized to an OEM and does that allow you to have smoother decrementals when one model, one factory is up, one factory is down on your customers' end?

Jeff Cote, CEO

Yes, not all of our products are like that. We have 15,000 different products that we offer to customers; they are tailored for specific applications, and many of them are often sourced exclusively from us. I believe we have managed our inventory well; we’re not the bottleneck for our customers, which is a good position to be in. We are collaborating with many customers and I've had discussions with numerous ones, and the feedback indicates that we aren't their main issue. I prefer not to be the largest concern, and I don't mind building some inventory as a buffer for our customers. However, I want to ensure that it doesn’t get out of control because eventually that inventory will need to be utilized, and that could affect our performance down the line. We aim to ensure that good performance during challenging times doesn't lead to long-term drawbacks, so we are monitoring the situation closely.

Jacob Sayer, VP, Finance

Thanks, Brian.

Operator, Operator

Our next question comes from Samik Chatterjee with JPMorgan. Please go ahead.

Samik Chatterjee, Analyst

Yes. Hi, it's Samik Chatterjee. Hey, Jeff, you mentioned the content outperformance since 2018, which was previously noted to be between 400 to 600 basis points, and you've consistently exceeded that in both the automotive and heavy vehicle sectors. I'm curious about your plans regarding electrification and battery electric vehicles. Can you share your insights on enhancing that performance guidance? Also, are there any concerns about facing challenges during the industry's transition, or do you anticipate a smooth progression in content outperformance moving forward? Thank you.

Jeff Cote, CEO

Thank you, Samik. Historically, we've highlighted growth in automotive and HVOR, and while we aimed to create more transparency, it seems we may have complicated the narrative. Ultimately, our objective is to ensure that our growth outpaces the market, acknowledging that market conditions will fluctuate based on the sectors we operate in. This is why we've indicated an increase of 570 basis points into 18 across the company, primarily driven by HVOR and automotive sectors. We also see growth in industrial and aerospace, although it is less pronounced. We're projecting growth of 400 to 500, and we're confident in this outlook, particularly in the near term. This confidence stems from our performance relative to the smaller base in 2020. As we transition to a more normalized environment, we expect those growth figures to stabilize somewhat. We're focused on providing projections we feel certain about, having consistently outperformed previous targets. We aim to maintain this track record, feeling assured about the 400 to 500 growth across the company, alongside our projections of 4 to 6 in automotive and 6 to 8 in HVOR moving forward. I hope this clarifies things.

Jacob Sayer, VP, Finance

Thank you, Samik.

Operator, Operator

Our next question comes from Michael Filatov with Berenberg. Please go ahead.

Michael Filatov, Analyst

Hi. Good morning, guys. Thanks for the time. Just on the doubling of the EV content, not to beat a dead horse there. Just the margin profile of that extra content you're seeing on electric vehicles, because maybe talk about how that'll impact sort of the business margin. And maybe where that margin profile is more attractive within the actual electric vehicle content mix.

Jeff Cote, CEO

Yes, we focus exclusively on challenging applications that enable us to achieve differentiated margins. We avoid commoditized applications that can be handled with standard semiconductor packaging, which don't require advanced packaging or environmental controls for tough conditions. While those applications are valuable, they can be addressed by others. Our strengths lie in applications that are complex in harsh environments, and that’s where we excel. We remain committed to this area, as it generates the premium margins we see as a company. Regarding new product launches, we have observed that new products with lower volumes often come with lower margins. However, as production ramps up, we work through the initial challenges of automated manufacturing, achieve greater scale with our raw materials, and improve our factory capabilities, which significantly boosts our yields. We are considering these factors and do not expect the transition to be significantly disruptive. The long-term margin profile for these products we are collaborating on with our customers will maintain the differentiated margins we have as a company. We will ensure this outcome through continuous scale development and constant redesign to manage sourcing effectively, which is essential for maintaining our competitive cost structure.

Jacob Sayer, VP, Finance

Thank you, Michael.

Operator, Operator

Our next question comes from William Stein with Truist Securities. Please go ahead.

William Stein, Analyst

Thank you for taking my question. We've talked a lot about inventory levels, but I still have a question. I would like to summarize everything into one comment. Could you remind us how much of the excess inventory you mentioned last quarter was in raw form for your customers? Specifically, were they holding your parts, or was it more about cars that were nearly complete but just needed one semiconductor? Also, could you tell us the dollar amount of excess inventory you believe was present last quarter and what it is this quarter? I might have missed some figures. Additionally, when do you expect that inventory to be reduced? If that wasn’t enough, could you also discuss the planned inventory builds that OEMs are considering for strategic components? Does that impact your part build plan? Sorry for the lengthy question. Thank you.

Jeff Cote, CEO

Yes, I will try to clarify. We believe that our customers accumulated approximately $25 million in inventory in the second quarter and $35 million this quarter. As a result, we are shipping more than our production levels. Additionally, we consider ourselves a strong supplier without bottlenecks. While there is no definitive evidence to support this, it seems likely that many of our parts are currently in vehicles that are still being assembled and will eventually be available in the market. Given our effective shipping, we are actively engaging in discussions to address their needs, although there is considerable concern in the supply chain.

Paul Vasington, CFO

That's how I would summarize the situation this year. It's difficult to predict when things will stabilize. However, as Jeff mentioned, dealership inventory levels are quite low, which suggests that there will need to be a rebuild, and that is a positive development. This serves as a favorable factor in the current circumstances. I don't expect this will significantly alter the existing supply chain challenges we are experiencing, but it does offer some longer-term relief regarding the inventory that has accumulated in the channel.

Jacob Sayer, VP, Finance

Thanks for the question, Will.

Operator, Operator

Our next question comes from Nick Todorov with Longbow. Please go ahead.

Nikolay Todorov, Analyst

Yes. Hi, thanks. Good morning, everyone. Jeff, I think I heard you talk about implementing differentiated or different commercial approach to addressing the rising costs. Maybe can you expand there, what are you doing differently? When you negotiate those with direct customers? And maybe can you talk about how much of the installation costs you've seen so far, you've been able to pass through to direct customers so far this year? And how should investors think about once we start a new calendar year in terms of passing through those? Thanks.

Jeff Cote, CEO

In 2021, we have managed to recover about half of the costs we've faced. Since we anticipate these costs will persist, our goal is to recover all of them moving forward. We achieved this in the third and fourth quarters. In the first half of the year, we paused on this approach until we could assess whether the costs were going to be ongoing. Each customer is unique, and the trade-offs vary accordingly. Our strategy for engaging with customers focuses on optimizing all the resources we have available. We are committed to serving our customers while also sharing the costs tied to achieving that.

Jacob Sayer, VP, Finance

Thanks, Nick.

Operator, Operator

Our next question comes from Rod Lache with Wolfe Research. Please go ahead.

Shreyas Patil, Analyst

Hey, thanks. This is Shreyas on for Rod. I wanted to clarify a couple of points. You mentioned earlier that there was about $100 million to $125 million of inventory costs this year. Should we assume that inventory will decrease as we move through Q4 and into next year? Is that included in the 4 to 5 points of growth over market that you mentioned before? Also, you noted a recovery in some of the supply chain costs you've been facing this year. Does that mean that, all else being equal, the challenges you've been dealing with this year could lessen if these recoveries continue?

Paul Vasington, CFO

To try and keep it simple. I mean, our Q3 revenue production was 14.4. But we benefited from it from inventory build, right. In Q4, production is 15 million, so with about 4%, we're not assuming that inventory builds will continue. That's the difference in our automotive businesses, slightly down. You're right. Sequentially. Those are the dynamics because we're not expecting to get that additional revenue from shipping more than what's being produced at the OEM.

Jeff Cote, CEO

Yes, and that's auto, right. So on HBO, Q3 to Q4, we're expecting the market to contract a little bit; industrial Q3 to Q4, we're expecting the market to contract a little bit. Yes, that's seasonal, right. But that has to be factored into the Q3, Q4 transition as well; aero is the other one, that's up a tiny bit from Q3 to Q4. So when you look at the whole mix of the business, it's complicated. But when you look at the whole mix, the guide makes sense and it's just a lot of moving.

Paul Vasington, CFO

In the fills in 95%, a little bit less than last quarter. But last quarter, we're expecting more orders to drop out, given some of the shutdowns we're expecting a little less than that. So that's why the fill being a little lower, you think is appropriate given where we're forecasting the revenue to be at the midpoint of guide. It's largely consistent with what we saw in Q3.

Jacob Sayer, VP, Finance

Thanks, Joe.

Operator, Operator

Our next question comes from David Kelley with Jefferies. Please go ahead.

David Kelley, Analyst

Hey, good morning guys and thanks for taking my question. Maybe just a question on the fourth quarter margin guidance and the sequential view that stepped down from Q3, I'm assuming in part related to this sequential guided revenue step down. But could you just give us a sense of how you're thinking about some of the sequential input cost levers into the fourth quarter if there's anything mix related we should be thinking through and modeling?

Paul Vasington, CFO

You got it right. The difference from Q3 to Q4, the drop, we are dropping about $40 million-ish revenue and about $16 is coming out on the bottom line. So it's conversion; a lot of it is just volume conversion and leverage that we lose. There is a little bit of an expectation of higher logistics costs as logistics rates continue to eke up just given the constraints or global logistics channels. Those would be the two main drivers sequentially.

Jacob Sayer, VP, Finance

Thanks, David.

Operator, Operator

Our next question comes from Christopher Snyder with UBS. Please go ahead.

Christopher Snyder, Analyst

Thanks for squeezing me in. Also just kind of want to follow-up on the commentary on the EV content per vehicle, can be double IC within 5 years, because this is a really significant change from the recent plus 20% run rate. So this kind of impact is more, as I guess it's not super clear to me, what is driving that 80% delta relative to expectations just 3 to 6 months ago. Is that the market opportunity is stronger than previously thought? Are share gains accelerating kind of based on what you're seeing on orders? And I just want to confirm that this does not include incremental M&A.

Jeff Cote, CEO

Yes, it does not include additional mergers and acquisitions. The 20% represents a proven capability when you consider the total revenue from electric vehicles in 2020 and 2021 divided by the number of electric vehicles produced, showing a 20% increase compared to the rest of the automotive business. A lot needs to happen to assess how these vehicle platforms will develop, as much of the business is interconnected. We have a long-term business cycle, and in recent years, we've highlighted the number of new business wins focused on electric vehicles. We're gaining better insights into which of our capabilities or products will align with the new electrified platforms as our customers finalize their launch timelines. We’re offering visibility into what we expect over the next three to five years and how this will evolve. While the final outcome regarding the number of electric vehicles remains uncertain, if you consider a scenario of 25% to 30% of the total vehicle market being electric in five years, the market will expand and the content will increase. In the electric vehicle segment, we expect to see additional content in light vehicles and even more so in stationary equipment and heavy vehicle sectors where we provide more than just sensor content. This is an exciting and rapidly evolving area that will continue to yield data points and benchmarks to track our progress.

Jacob Sayer, VP, Finance

Thanks, Chris.

Operator, Operator

Our next question comes from Joe Giordano with Cowen. Please go ahead.

Joseph Giordano, Analyst

Hey, everyone. I believe we've covered most topics at this stage, but I'm curious about how scaling your content relates to ongoing megatrends, especially with the various bolt-on acquisitions. Will the influence of those megatrends increase with those acquisitions? How do you envision this evolving over the next few years?

Jeff Cote, CEO

I think for next year our current planning model is to maintain a spending range of $50 million to $55 million for megatrends. The allocation of that spending may change, potentially shifting towards areas where we anticipate the greatest success in scaling growth. We will share more details as we finalize our guidance for next year, but for now, the target is to keep that aggregate number around $55 million.

Jacob Sayer, VP, Finance

Thanks, Joe.

Operator, Operator

Our next question comes from Jim Suva with Citi. Please go ahead.

Jim Suva, Analyst

Thank you for all the details thus far. A question on the logistics and the supply chain issues. Are you having to or starting to consider putting into your contracts, like additional riders, or I guess indexing to raw materials or shipping or things like that? Because I'm just wondering if these things are prolonged, so it could potentially protect your profitability somewhere. I’m just kind of wondering how it's going, because I know you have very long-term relationships with your customers and a long sight of visibility into the designs. Thank you.

Jeff Cote, CEO

Yes, that's a great question, Jim. In our typical contracts, it’s common to include rate of exchange or metal commodity riders. However, I haven't encountered many commercial agreements with inflation riders, though we are definitely discussing them. On the legal side, it's important to acknowledge that our customers expect us to support them. We have built strong, long-term relationships with our customers over decades. We will work together to find the right solutions to address this challenge. While these discussions are never easy, our customers are aware of the current circumstances that everyone is facing. Overall, we feel positive about our situation. We will further explore the contractual aspects while engaging in a dialogue about how we can partner effectively.

Jacob Sayer, VP, Finance

Thanks, Jim.

Operator, Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Jacob Sayer for any closing remarks.

Jacob Sayer, VP, Finance

I'd like to thank everyone for joining us this morning and for hanging in there through all those questions. Sensata will be participating in upcoming investor conferences this quarter, including Baird's Industrial Conference and Industrial Conference in New York during the quarter. As Jeff mentioned, we also expect to offer a webinar on our electrification components and clean energy solutions initiatives early next year. We look forward to seeing you at one of those events or on our fourth quarter earnings call in early February. Thank you all for joining us this morning and for your interest in Sensata. Operator, you may now end the call.

Operator, Operator

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.